Fiscal policy is best way to tame flying rouble

Pity the Bank of Russia. It is fighting a losing battle against the
strengthening rouble. Further cuts in interest rates will only provide
limited relief. Something stronger is needed to combat the "Dutch
Disease".

3:00PM GMT 16 Mar 2010

That's one name economists give to a problem caused by abundant exports of natural resources. The inflow of foreign currency pushes up the exchange rate and makes other domestic industries uncompetitive with foreign producers. Resources flourish, everything else atrophies.

Whether Russia has actually suffered from the disease, first identified in the Netherlands in the 1960s, is open to debate. The real exchange rate of the rouble has doubled over the last decade - including a 15 percent nominal rise against the central bank's euro-dollar basket in the last year - but it's not clear how much manufacturing has suffered.

But even if oil prices do not keep rising, both monetary and fiscal policies are exacerbating the problem. On the monetary side, the Russian central bank is now keen to keep interest rates above inflation, which it often failed to do in the past. Recent cuts have been slower than the fall in inflation, with real interest rates much higher than they were in previous years. This tighter policy is desirable for financial stability, but it will also help keep the rouble strong.

The shift in fiscal policy is even more troubling. For most of the last decade, Russia followed the textbook on the Dutch disease. Large budget surpluses were stored in an offshore Reserve Fund, in effect keeping much of the gains from oil exports outside of the country.

Now the flow is in the other direction. Russia is running down its Reserve Fund to finance a big fiscal deficit, projected at 7.2 percent of GDP this year. Worth $137 billion at the start of 2009, the fund is set to be completely exhausted by the end of 2010. Russia even wishes to resume borrowing abroad -- it has pencilled in $17.8 billion this year. That will only increase the hard currency inflow.

Borrowing may be justified at times of crisis. Yet Russia is not expecting to return to a budget surplus until 2014. In the interim, the Dutch Disease could spread. The sooner it starts taking its fiscal medicine again, the better.